Chinese shares not bottoming?

We argued, with Jim Rogers, that Chinese shares should offer compelling value pretty soon. There are other views around and here is an article that argues the bottom in Chinese shares is not in sight. It makes a couple of good points, so let’s discuss…

Our arguments for saying we could expect a rebound in Chinese shares were:

  1. Since Nov 2007, there has been a massive correction (>60%)
  2. The economy might slow a little bit, but 8% growth should still be good enough for underlying profit growth
  3. The Chinese economy is shifting from export led to domestic led growth, wages and retail sales are growing at dizzying pace and the authorities have embarked on a 58B stimulus package
  4. We expected some form of government intervention to shoot the bear market down (we are hardly alone in that, and there have been some indications as we mentioned).

Now, our second argument especially might be less forceful than we previously thought. From SeekingAlfpha:

  • At current valuations, the Shanghai Composite Index has an average P/E ratio of 19. Now this may not sound particularly high for an economy that is expected to grow at 8.6% this year, but you should bear in mind that between 2004 and 2006, when the Chinese economy was growing at 11% +, the Shanghai Composite’s average P/E ration never exceeded 13 times earnings. It’s reasonable to assume that when this market does finally bottom, it may well be trading at a low double or high single digit P/E.
  • In the developed economies, having growth rates of 8% would mean a stock market boom, but having growth slow this much in China is going to have a significant impact on many companies. Many firms operate their businesses on razor thin profit margins; they rely on constantly growing their top line to support their business model. With growth slowing from double digits, many of these companies will no longer be able to maintain profitability and some will simply go out of business.
  • A period of consolidation is what this market requires. As a number of competitors fall by the wayside, the survivors will be rewarded with greater pricing power in a less cut-throat competitive environment. This process will not happen overnight; in fact, it may take a couple of years, so don’t expect the post Olympic capitulation to usher in a new bull market.

Having written quite a bit (in a previous life as academics) about Japanese companies in the 1980s and 1990s, how they put market share and growth above profit, we forgot to take into account that Chinese companies are quite similar in that respect.

We’re also not unfamiliar with some of the mechanisms in such a high growth economy. We did realize (in fact, we’ve argued this on several occasions here) that these Asian economies are very dependent on their high growth rate, they’re a little bit like bicycles, if they slow down, they tend to fall over.

If any unforeseen crisis slows them down then the whole motor is stuttering to a grinding halt, and much has high growth expectations built in:

  1. High growth is often investment led, if growth falters this can quickly lead to overcapacity (and price wars especially in those sectors where fixed cost play an important role), which also leads to profit margin decline
  2. Overcapacity slams investment in new capacity, which exacerbates the slowdown
  3. The slowdown will affect asset prices (from equity to real estate)
  4. Falling asset prices will affect credibility of a host of borrowers, which could very well lead to an increase in bad loans (and could even lead to a banking crisis)
  5. The increase in bad loans could make banks more wary, reducing the supply of credit, exacerbating the slow down..

Much of this one could have seen in action during the Asian crisis in 1997. Now, although we perhaps insufficiently argued the case, but one of the reasons we did expect Chinese shares to rebound pretty soon is based on our reading of the Chinese authorities.

We think authorities are all too aware of these characteristics of their economy, and during the last 20 years or so, if anything, the Chinese authorities have been obsessed with maintaining rapid economic growth.

We also realize that the prime argument for that has always been to maintain stability, as the mass migration from the countryside (low productivity jobs) to the cities (higher productivity jobs) needs large economic growth to create those jobs.

In effect, economic growth needs to be higher than productivity growth (luckily, Chinese population is not growing at a brisk rate, economic growth would have to be even larger to accommodate that) if it is to add any jobs (and maintain social order and communist party legitimacy).

But once that high growth path becomes entrenched, the ‘bicycle’ character of the economy as roughly set out in the mechanisms 1 to 5 above takes an importance of its own, and reinforces the prime drive of the authorities to maintain economic growth, almost at any price.

And as we showed in another article, authorities have embarked on stimulating domestic, consumer led demand now that exports are slowing, and they are already embarking on big stimulus packages, which led us to believe a bottom in the market must come soon.

The author  of the SA article also had something to say about those who are waiting for government rescue:

  • The Shanghai stock market is once again waiting for the Mandarins. This time, investors are waiting for the government to intervene to prop up a falling market. Since it began its long decline in November of last year, the rumour had gone around that the government will ride to the market’s rescue because this was the year of the Olympics and the government would want to avoid any unrest.
  • Many grimly hung on to their stock positions as the market began its long decent, believing that the government would intervene. The Olympics are almost over and they are still waiting. Very soon, perhaps during the closing ceremonies, it will dawn on them that there will be no rescue this time. This will be when the market finally accepts reality and will reach its bottom.

Well, the jury is still out. The authorities are already shifting gears with the stimulus package, and one easy, and cheap way to improve sentiment is to nudge margin requirements lower (one of a couple of subtle instruments the authorities have in signalling all systems go to the markets).

We were never 100% convinced a turn around in the Chinese markets were imminent (one can never be, needless to say) and in fact, there was a comment to the SA article that made another couple of valid points against such an impending turn-around scenario:

  • I think you no longer live in shanghai. if you do, you’ll be worried about the popping of the real estate bubble. the stock market is still overvalued because:
  • 1. there’s an ongoing nationwide bust of the real estate bubble; many of the big name homebuilder’s debt are trading at junk spread. we’ll see a couple of them go belly up soon.
  • 2. banks of course will be saddled with bad debts from the real estate sector.
  • 3. concentrated unlocking of huge amount of shares are flooding the market after the “success” of the full-float stock reform. many garbage stocks will drop 80% from where they are now.
  • 4. many stocks are still trading 30%+ premiums to their H shares listed in HK.
  • 5. millions of mutual fund newbies bought when the index was in 4000-6000, now they are under water by 40-50%.
  • 6. we’re still far from the bottom in the US housing and stock market
  • 7. if HK properties collapses and HK stock market goes down further, they add more downside pressure on china’s properties and stock market. a lot of high-end condos in shanghai are bought up by investors from HK.
  • conclusion: china’s stock market has a lot more downside than many foreigners think possible. be patient, you’ll be able to get in when it reaches 1000 again.

Well, 1000, that’s very gloomy, but after reading this stuff we’ve become a little less optimistic about an impending turn-around in the Chinese markets. But we still think it’s very likely those Mandarins will start to intervene long before the Shanghai index hits 1000. It’s been done before..

Having said this, we do not see signs of faltering demand for the products and services of the one Chinese company we’re following (eFuture), business software applications like supply chain management software is a growth market still in it’s infancy, and the retail sector where eFuture’s application are a market leader is especially growing at a very brisk pace.

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